What will Trump's revamping of NAFTA change? － It will not help US employment or hurt Japanese automakers.

On August 27, the United States and Mexico reached a deal on changes to the North American Free Trade Agreement (NAFTA) to the exclusion of Canada. It is up to future negotiations whether a revamped NAFTA will be modified to the satisfaction of Canada or remain a deal just between the US and Mexico.

The media reports that future negotiations will be bumpy for Canada as the country is under increasing pressure to accept the same content as the US-Mexico deal and increase market access to its dairy products, a politically sensitive issue. US President Donald Trump says he will exclude Canada if it refuses to agree to the bilateral deal.

A new NAFTA deprived of "freedom"

The gist of the US-Mexico deal is that the US will not allow Mexico to export automobiles tariff-free into the US unless they use an overwhelming portion of parts made in the US. In other words, the US will only allow autos that can be described as almost US-made.

According to Japanese media reports, the new deal has two criteria for parts content.

One criterion requires increasing the percentage of parts made in the US and Mexico (including Canada if it agrees to a deal) from 62.5 percent to 75 percent. The other criterion, newly established, requires that 40 to 45 percent of all parts be made by workers whose hourly wage is 16 dollars or more. (This is tantamount to requiring procuring parts from the US because the average wage in Mexico is as low as seven dollars an hour.)

The message is clear: The new deal intends to increase employment in the US by raising the percentage of US-made components.

This clearly goes against the spirit of a free trade agreement, which is designed to allow the import of foreign-made goods if they are cheaper than their domestic counterparts.

In the context of NAFTA, the US is supposed to import autos from Mexico because that is more cost-efficient. If the US wants to import autos that can be described as almost US-made from Mexico, why has the US signed the free trade pact in the first place? That's nonsense.

More specifically, a free trade agreement is designed to benefit industries with a lower production cost in the exporting country (Mexican automobiles in the case of NAFTA) as well as consumers in the importing country through the purchase of their products with lower price (the US consumers of automobiles in the case of NAFTA). The recent bilateral deal, however, is intended to increase production and employment in US industries with a higher production cost and impose higher prices on consumers.

This is tantamount to "depriving NAFTA of freedom."

Implications for Japanese automakers operating in Mexico

Newspapers say that Japanese firms that manufacture products in Mexico and export them tariff-free to the US will face the stark choice of significantly increasing the percentage of parts procured from the US or, if that is difficult, paying a tariff of 2.5 percent for exports to the US. If Canada and the US fail to reach a deal, a uniform tariff of 2.5 percent will be levied on the former's exports to the latter.

Trade figures for 2017 show that, of US annual auto sales of 17.58 million units (of which 6.7 million were Japanese vehicles), 2.7 million were imported from Mexico (of which 0.69 million were Japanese vehicles) and 1.89 million from Canada (of which 0.77 million were Japanese vehicles), according to the Japanese financial daily Nihon Keizai Shimbun dated August 29.

The impact of a revamped NAFTA will be greater for Japanese automakers operating in Mexico than for its US counterparts, as the former likely uses a smaller portion of US-made parts. If Japanese automakers want to benefit from zero tariffs, they may have to procure more parts from US suppliers.

Alternatively, Japanese automakers may prefer paying a tariff of 2.5 percent to using more costly US parts as they must have transferred some of their operations to Mexico in view of the total costs involved, including the cost of the parts. Switching parts suppliers might be all the more difficult because Japanese parts manufacturers have also transferred some of their operations to Mexico.

Better to manufacture in Mexico than in the US

However, my initial analysis of the US-Mexico deal when I learned about it from media reports differed from the analyses by newspapers. The recent deal needs to be evaluated in the wider context of Trump's overall trade policy.

Mexico agreed to changes to NAFTA because Trump threatened to raise the auto tariff to 25 percent. Now that Trump has made that threat to Mexico, he will eventually raise the tariff to 25 percent on auto imports from all over the world.

In that case, Mexico will be able to export autos that meet the parts content criteria to the US with no tariffs; however, a 25 percent tariff will entail for other autos. With such a huge gap in tariffs, Japanese automakers seem to have no choice but to procure more parts from US suppliers.

My analysis does not end there, however.

Let's take a moment here to identify the cost implications of increasing the auto tariff from 2.5 percent to 25 percent for the automobile industry.

The rate of cost increase will be 22.5 percent for autos exported from Japan to the US, 13 percent for autos locally manufactured by Japanese automakers because of additional tariffs on parts from Japan and on steel, and 10 percent for autos domestically produced by US automakers (see "The Japanese and US automobile industries will have a showdown in the Chinese market") on the assumption that the cost will increase by 5 percent due to the impact that additional tariffs on steel have on US-made parts.

Now, let's estimate the rate of cost increase for autos made in Mexico based on the recently agreed criteria for parts content.

Assume that Mexico imposes no tariffs on parts imported from anywhere and that the price of parts without tariffs is the same wherever they are produced. Also assume that the cost of parts accounts for 90 percent of the total production cost (with the remaining 10 percent being the value added in the process of fabrication by the automakers). If Japanese automakers procure 45 percent of all parts from the US (entailing a cost increase of 5 percent), 30 percent from Mexico (entailing no cost increase)--note that the criterion of 75 percent regional parts content is already satisfied--and the remaining 25 percent from Japan (again, entailing no cost increase), the rate of cost increase for parts will be 2.25 percent (45% × 5% + 30% × 0 + 25% × 0 = 2.25%). As the cost of parts represents 90 percent of the total cost, the rate of total cost increase for autos will be about 2 percent (2.25% × 90% = 2.025%). (Note that the rate of cost increase will be higher for US automakers as they procure a larger portion of their parts from the US.)

In sum, the rate of cost increase for auto production will be 2 percent for vehicles that Japanese automakers manufacture in Mexico if they meet the agreed criterion for regionally sourced parts (a little higher for their US counterparts), 10 percent for vehicles that US automakers manufacture in the US, 13 percent for vehicles that Japanese automakers manufacture in the US, and 22.5 percent for vehicles they export from Japan to the US.

Clearly, it will be more advantageous to produce autos in Mexico than in the US.

If transferring a production base abroad is not so costly, both Japanese and US automakers will likely opt for production in Mexico. Japanese automakers will use US-made parts in Mexico as well. However, the percentage of such parts will make up only 45 percent. The result will be a significant drop in production and employment for the US automobile industry.

Much better to manufacture in Canada

How about auto production in Canada?

There will be cost pressure for auto production in Canada because parts made in Canada will be free from the impact of additional tariffs on steel, unlike US-made parts. If Canada-made parts and their US counterparts are no different in price and quality, automakers will likely opt for the former rather than the latter, which will entail transportation costs and suffer from additional tariffs on steel. Assuming that wage levels are similar in Canada and the US, the parts content criterion concerning wages can easily be satisfied with the use of Canada-made parts.

In other words, automakers in Canada will meet the criteria for exports to the US just by procuring 75 percent of all parts from Canada and Mexico, of which 45 percentage points or more will come from Canada. In this case, the rate of cost increase for auto production in Canada will be zero in the absence of US-made parts.

If the auto tariff is raised to 25 percent, it will be more advantageous to produce autos in Canada than in Mexico. The use of US-made parts will paradoxically be reduced since it will generate cost pressure. The impact on the auto industry and employment in the US will be greater than in the case of Mexico.

Trump intended to create more American jobs by raising auto tariffs so that Japanese and other automakers will produce more vehicles in the US. That intention will backfire under a new NAFTA. The US auto industry will likely transfer operations to Canada and Mexico, thus reducing employment opportunities in the US. Ironically, Trump's attempt to protect the US automobile industry and the workers in the Rust Belt who supported him might destroy them.

The new bilateral deal revealed

This was my analysis based on initial media reports on the new deal between the US and Mexico.

However, one of the assumptions for my initial analysis was rendered irrelevant when the Nihon Keizai Shimbun dated August 31 revealed what the Mexican economic minister said on August 29. According to the Japanese financial daily, the minister said that the new bilateral deal stipulates that a 25 percent tariff be imposed if exports from Mexico to the US exceed 2.4 million tons. The article added that Mexico's exports to the US for 2017 amounted to 1.7 million tons (which does not match the earlier figure). Accordingly, exports of 2.4 million tons represent 140 percent of the 2017 level.

In short, the tariff rate for autos will be zero if the parts content criteria are met, 2.5 percent on other occasions, and 25 percent if exports exceed 2.4 million tons. As my analysis predicted, the new deal is found to have made prior arrangements for raising the auto tariff to 25 percent. (When the US raises the auto tariff to that level, there will be no exports with a 2.5 percent tariff.)

My initial analysis assumed that there will be no numerical ceiling on auto exports as long as they meet the parts content criteria. The revealed stipulation, however, is that zero auto tariff will not be applied to exports that exceed a certain limit even if they satisfy the parts content criteria.

Negotiators at the United States Trade Representative (USTR) must have had a vague sense of anxiety similar to my analysis. A cap has been imposed on the growth of manufacturing in Mexico.

These USTR officials may be fine negotiators but they are a failure as law practitioners. The revealed stipulation of the deal violates a number of WTO rules.

First of all, the US set a 25 percent auto tariff, far above the 2.5 percent tariff it committed to the WTO. WTO generally prohibits import quotas, too. When imports surge, the WTO allows member states to impose import quotas or raise tariffs above the levels they have committed to only if an investigation by the affected country confirms that such a surge has caused, or is likely to cause, substantial damage to the domestic industries in these countries. The stipulation is not aligned with this arrangement, which is referred to as the safeguard mechanism. In addition, the stipulation also goes against the principles of a free trade agreement, which is designed to lower protection levels.

It might be that Washington could not care less about the WTO any more.

US jobs not created

The revealed content of the deal suggests that USTR negotiators are also aware that the free trade deal with Mexico might hurt the US auto industry.

If that is the case, USTR negotiators might impose strict conditions on Canada similar to those imposed on Mexico. Of the two parts content criteria, the one regarding wage levels is irrelevant to Canada. Accordingly, the US might impose a more stringent numerical ceiling. That ceiling might be 130 percent of the current export level for Canada as against 140 percent for Mexico.

Trump was elected US president on the campaign promise that he will increase employment in the country. Trump's behavior is said to be unpredictable, but it is predictable in that he will remain committed to the campaign promises he made. He is now trying to protect employment in the US auto industry by increasing the percentage of US-made parts.

Yet, a 25 percent auto tariff will make production in Mexico far more advantageous than production in the US, even though restrictions regarding parts content criteria will increase. This is why Washington had to impose a ceiling below which exports are tariff-free. Viewed conversely, the ceiling will only serve as a brake on production growth in Mexico and production shrinkage in the US. This is only a defensive measure; it will not increase employment in the US.

(This article was translated from the Japanese transcript of Dr. Yamashita's column in "Webronza" on September 3, 2018.)